The relationship between monetary aggregates and economic growth, once a cornerstone of economics, has become increasingly tenuous in today’s financial landscape. As Federal Reserve Chair Jerome Powell noted, the classic connection we learned in textbooks “just no longer holds.” This shift necessitates a re-evaluation of traditional concepts like the “Money Multiplier” and how we understand the Federal Reserve’s influence on the economy.
Many introductory economics courses rely on outdated explanations of the link between banks, the Federal Reserve (Fed), and monetary policy. While the role of banks and the Fed within the U.S. financial system remains crucial, the mechanisms through which they interact have evolved significantly. Traditional teachings often emphasize the “money multiplier” as a key concept, but this framework is rooted in an obsolete understanding of Fed operations.
This article argues for the elimination of the money multiplier concept from educational materials. Instead, we advocate for a contemporary approach that highlights how the Fed manages interest rates, not monetary quantities, to influence the banking system and the broader economy. We will begin by outlining the roles of banks and the Fed, explore their current interconnections, and conclude by emphasizing the essential concepts for understanding modern monetary policy.
The Vital Role of Banks in the Financial System
Banks are central to the financial system, acting as intermediaries between savers and borrowers. They engage with a diverse range of consumers and businesses, playing a significant role in shaping savings and investment patterns. By the end of 2020, U.S. banks held approximately $20.5 trillion in assets, including $10 trillion in loans, and $16 trillion in deposits, which represent bank liabilities. These figures, while substantial, only partially capture the vast financial intermediation facilitated by banks. Beyond balance sheet activities, banks provide critical financial services, such as enabling payments throughout the economy and actively participating in financial markets to manage funds and liquidity.
Figure 1 provides a simplified view of a bank’s balance sheet, illustrating the primary assets and liabilities. For clarity, assets are categorized into loans, securities, and reserve balances. Reserve balances are the funds banks hold in their accounts at the Federal Reserve, analogous to a household’s checking account. Liabilities primarily consist of customer deposits, for which banks pay interest. The specific amounts in Figure 1 are for illustrative purposes.
Figure 1: A simplified bank balance sheet showing assets like loans, securities, and reserve balances and liabilities as deposits.
Numerous factors influence a bank’s balance sheet size and composition. Banks, as profit-seeking entities, make strategic decisions based on expected returns and associated risks. These risks include credit risk (the potential for borrowers to default) and liquidity risk (the ease of converting assets to cash). Banks operate under regulatory frameworks that mandate maintaining adequate financial capital as a buffer against potential losses and liquidity shortages. Customer behavior, specifically the demand for loans, deposits, and other banking services, also significantly shapes bank balance sheets.
Consider a bank’s asset allocation decisions, using Figure 1 as a reference. Interest rates are a key determinant in allocating funds across loans, securities, and reserve balances. Banks establish loan rates to generate income from borrowers. These rates, in turn, influence loan demand from households and businesses. To ensure profitability, loan rates are typically set above the deposit rates offered to customers. Investment in securities, such as U.S. Treasury securities, is guided by market interest rates, balancing lower risk with returns generally between cash and loans. Reserve balances offer high liquidity. The Fed provides interest on reserve balances (IORB) at a rate it determines, the IORB rate. This rate is usually lower than other investment returns due to the immediate availability and risk-free nature of reserve balances. The IORB rate acts as a reservation rate, setting a floor for banks’ investment returns.
The Fed, by setting the IORB rate, exerts influence over bank decisions, including deposit and loan rates. These bank-level decisions ultimately impact the cost and availability of credit for households and businesses. However, the IORB rate’s significance extends further. As an administered rate, directly set by the Federal Reserve, it is a primary tool for implementing monetary policy. Let’s now examine the Federal Reserve’s role and its policy implementation.
The Federal Reserve’s Role in Monetary Policy
The Federal Reserve, the central bank of the United States, is tasked with conducting monetary policy to achieve “maximum employment and stable prices,” a mandate from Congress. The Federal Open Market Committee (FOMC), the Fed’s policy-making body, convenes regularly to assess economic conditions and set the stance of monetary policy to guide employment and inflation.
Figure 2 illustrates the FOMC’s policy actions and their transmission to the economy. At each meeting, the FOMC evaluates current and projected economic conditions. Based on this assessment, the FOMC sets a target range for the federal funds rate, the interest rate at which banks lend reserve balances to each other overnight. This policy rate is the primary tool for adjusting monetary policy. The FOMC may tighten policy by raising the target range, ease policy by lowering it, or maintain the current stance by leaving the range unchanged.
Figure 2: Diagram illustrating the Fed’s monetary policy actions, from setting the federal funds rate target to achieving the dual mandate of maximum employment and stable prices.
To implement these policy decisions, the Fed employs tools to maintain the federal funds rate within the target range. For over a decade, the Fed has operated with ample reserves in the banking system, primarily using the IORB rate as its implementation tool.
As shown in the table below, adjustments to the IORB rate are typically aligned with changes to the federal funds rate target range. Raising the target range is accompanied by an increase in the IORB rate (tightening policy), while lowering the range involves decreasing the IORB rate (easing policy). The Fed uses IORB and other tools to ensure effective monetary transmission, channeling policy changes through the economy.
| FOMC’s Policy Rate Decisions | ||
|---|---|---|
| Desired change in policy stance | FOMC policy rate decision | Policy implementation |
| Tighten | FOMC raises the target range for the federal funds rate | Fed raises its administered rates including the IORB rate |
| Ease | FOMC lowers the target range for the federal funds rate | Fed lowers its administered rates including the IORB rate |
| No change | FOMC leaves the target range for the federal funds rate unchanged | Fed leaves its administered rates unchanged |
For instance, an increase in the IORB rate makes holding reserve balances at the Fed more attractive for banks. This elevates the reservation rate for banks’ investment decisions, as they are unlikely to accept returns lower than the IORB rate. Arbitrage mechanisms then propagate this effect to other market interest rates, including the federal funds rate.
This interest-rate-centric policy has proven effective in recent years. Figure 3 demonstrates how the Fed has successfully maintained the federal funds rate within its target range by adjusting the IORB rate in tandem with changes to the target range. This approach, utilizing IORB as the primary tool in an ample-reserves regime, has been affirmed by the FOMC as its long-term implementation strategy.
Figure 3: Line graph illustrating monetary policy with ample reserves, showing the IORB rate and federal funds rate from 2015 to 2021 and demonstrating how the IORB rate helps steer the federal funds rate into the FOMC’s target range.
Changes in the IORB rate ripple through the economy, influencing not only the federal funds rate but also a wide array of interest rates and broader financial conditions. As mentioned, these adjustments impact bank loan rates for consumers and businesses. They also anchor short-term market rates and influence longer-term rates. Furthermore, shifts in interest rate levels affect the valuation of financial assets like stocks and non-financial assets such as housing. These changes in financial conditions subsequently shape spending and investment decisions by households and businesses. For example, increased interest rates might deter businesses from borrowing, while rising asset values could encourage household spending.
As households and businesses adjust their spending and saving behaviors, aggregate demand and supply in the economy are affected. These shifts in demand and supply influence the demand for labor and other production inputs, and ultimately, the prices of goods and services. Thus, the FOMC’s monetary policy stance directly impacts the economy’s trajectory towards the dual mandate of maximum employment and stable prices.
The Interconnection Between the Fed and Banks
The primary link between the Fed and banks operates through the IORB rate. By raising the IORB rate, the Fed increases the return banks receive on reserve balances held at the Federal Reserve. This establishes a higher reservation rate for banks’ investment decisions, ensuring they will generally not accept lower returns on alternative investments. Arbitrage mechanisms ensure that this effect extends to other market interest rates, including the federal funds rate.
The Fed also utilizes forward guidance to communicate its intended future policy stance, influencing banks’ expectations and decisions. For instance, signaling an intention to maintain a constant policy rate for a specific period or until certain economic conditions are met shapes expectations for future short-term interest rates. Banks incorporate this information when setting longer-term interest rates, which are inherently linked to current and anticipated future short-term rates. Therefore, if Fed communication suggests future policy rate increases (and thus IORB rate increases), banks are likely to incrementally raise their loan rates. While the Fed interacts with banks through various channels, including setting other administered rates and overseeing bank supervision and regulation, the IORB rate remains the most critical linkage for monetary policy transmission.
Why the Money Multiplier Concept is Outdated
The Fed’s policy implementation framework is crucial for ensuring the FOMC’s policy rate decisions are effectively transmitted to financial markets and the broader economy. However, the significant operational shift the Fed underwent over a decade ago, moving to an ample-reserves framework, is not always reflected in educational materials. This can lead to fundamental misunderstandings about the relationship between banks and the Fed.
Two common inaccuracies in textbooks are:
- Outdated descriptions of Fed operations: Textbooks often describe the pre-2008, limited-reserves framework, emphasizing reserve quantities and open market operations. This contrasts sharply with the current ample-reserves framework that relies on administered interest rates, with IORB as the primary tool.
- Reliance on the money multiplier: Building on the outdated focus on reserve quantities, textbooks frequently link the Fed and banks through the money multiplier, suggesting monetary aggregates are a key transmission mechanism.
Let’s examine these inaccuracies in detail.
Mistake 1: Teaching an Obsolete View of Fed Operations
Some textbooks still portray the Fed operating under a limited-reserves regime, utilizing open market operations and reserve requirements as primary policy tools. Figure 4 illustrates that prior to mid-2008, reserves in the banking system were relatively scarce. Reserve requirements ensured a stable demand for reserves, and the Fed actively managed the supply of reserves through open market operations to influence the federal funds rate.
Figure 4: Line graph showing reserve balances in the banking system, highlighting the significant increase after the 2008 financial crisis and again in 2020.
However, the Global Financial Crisis of 2007-09 marked a turning point. The Fed lowered the policy rate to near zero and implemented balance sheet policy, including large-scale asset purchases (quantitative easing), to reduce longer-term interest rates and stimulate economic recovery. This dramatically increased reserve balances. A further surge in reserves occurred in March 2020 in response to the COVID-19 pandemic. In an ample-reserves environment, open market operations become ineffective in influencing the federal funds rate. Instead, the Fed relies on IORB as its principal tool.
The Fed has committed to maintaining an ample-reserves regime. Therefore, current instruction should focus on: ample reserves, IORB as the primary policy implementation tool, and the fundamentally different relationship between the Fed and banks in this new framework. This shift necessitates moving away from the money multiplier concept.
Mistake 2: The Irrelevance of the Money Multiplier
Outdated textbooks often emphasize the money multiplier to explain how money supply expands and contracts, linking reserve requirements to bank lending. The argument is that reserve requirements constrain bank lending, and the money multiplier quantifies this relationship. This concept suggests a direct and rigid link between banks, the Fed, and the money supply. The money multiplier is typically represented by the equation:
Money multiplier = 1 / RR
Where “RR” represents the reserve requirement ratio set by the Fed. This formula implies that the amount of money banks “create” is a multiple of reserves, inversely related to the reserve requirement ratio. For example, with a 10% reserve requirement, each additional dollar of reserves could theoretically lead to a $10 increase in the money supply. This perspective suggests reserve requirements are a potent monetary policy tool. However, this is no longer the case.
The money multiplier concept is no longer applicable in the current monetary policy environment. Firstly, while banks still prioritize profits, risks, and regulatory compliance when making loans, reserve requirements are no longer a constraint in an ample-reserves system. Secondly, even before the ample-reserves regime, reserve requirements had become less binding for many banks due to practices like retail sweep programs (explained further in the “Fade to Irrelevance” box). Thirdly, the Fed eliminated reserve requirements in March 2020, setting reserve requirement ratios to zero, acknowledging their lack of relevance in an ample-reserves framework. Mathematically, with RR = 0, the money multiplier equation becomes undefined.
The Fade to Irrelevance of the Money Multiplier
Figure 5 illustrates the declining relevance of the money multiplier by showing the ratio of M2 deposits to reserve balances. If the money multiplier were a stable concept, this ratio should be relatively constant. However, the chart reveals significant fluctuations. The ratio trended upwards in the 1990s, doubling from around 40 to 80 by 2000. This increase was partly due to retail sweep programs, which banks used to systematically minimize reserve requirements by shifting funds overnight from reservable to non-reservable accounts. This meant many banks, particularly large ones, were effectively unconstrained by reserve requirements long before they were formally eliminated.
Figure 5: Line graph showing the ratio of M2 deposits to reserve balances, illustrating the instability of the money multiplier over time.
Following the 2007-09 financial crisis, the ratio plummeted as reserve balances surged due to the Fed’s liquidity injections. Subsequent rounds of quantitative easing kept the ratio low. In the current ample-reserves regime, this ratio no longer holds its previous meaning. Furthermore, the level of reserves can fluctuate significantly when the Fed employs balance sheet policy. These factors render the money multiplier an outdated and misleading concept.
Therefore, educators should move away from teaching reserve requirements and the money multiplier. The focus should shift to banks’ investment and lending decisions, with the IORB rate as their key reservation rate.
Modernizing Economics Education: Key Concepts for the Classroom
To provide students with a current and accurate understanding of monetary policy, we recommend emphasizing the following key themes:
- The Fed’s Dual Mandate: Teach that Congress has charged the Fed with promoting maximum employment and stable prices. Highlight the extensive data, analysis, and research the Fed utilizes to assess economic conditions and guide policy decisions.
- Monetary Policy and Financial Conditions: Explain that the Fed influences the economy by adjusting overall financial conditions to steer economic activity towards its dual mandate.
- The Federal Funds Rate as the Policy Rate: Emphasize that the Fed primarily uses adjustments to the target range for the federal funds rate as its policy tool. Balance sheet policy is employed during periods of economic stress or to support recovery.
- Ample-Reserves Regime Implementation: Teach that the Fed operates under an ample-reserves regime, ensuring reserves are always plentiful. This framework ensures that changes in the federal funds rate target range translate to changes in short-term market interest rates.
- IORB as the Primary Tool: Explain that the IORB rate is the Fed’s main tool for implementing policy rate changes. It acts as a reservation rate, influencing market interest rates through arbitrage.
- Bank Lending Decisions: Teach that banks make lending decisions based on profitability, risk assessment, and regulatory considerations.
- IORB’s Influence on Banks: Explain how the Fed, through the IORB rate, influences banks’ decisions regarding deposit and loan rates, as well as lending and investment choices.
- Interest Rates and Monetary Transmission: Emphasize that monetary policy is transmitted through interest rates and financial markets. These changes in financial conditions affect household and business spending and saving decisions, ultimately impacting employment and prices.
- The Central Role of Interest Rates: Overall, stress the crucial role of interest rates in transmitting monetary policy changes to financial conditions and subsequently to the demand and supply of goods and services.
Glossary of Key Terms:
Administered rate: An interest rate set directly by a central bank, not determined by market forces.
Ample reserves regime: The Fed’s current monetary policy implementation approach characterized by a large supply of reserves, where small changes in reserve levels do not affect the federal funds rate.
Arbitrage: Simultaneous buying and selling of an asset in different markets to profit from price differences.
Asset: A resource with economic value expected to provide future benefits.
Balance sheet: A financial statement showing a firm’s or individual’s assets and liabilities at a specific time.
Balance sheet policy: Central bank use of large-scale asset purchases or sales to influence financial conditions, particularly longer-term interest rates.
Dual mandate: The Federal Reserve’s legal responsibility to promote maximum employment and stable prices.
Federal funds rate: The interest rate at which banks lend reserve balances to each other overnight.
Federal Open Market Committee (FOMC): The Fed committee responsible for monetary policy decisions.
Financial capital: Funds invested in a bank to absorb losses and protect depositors.
Forward guidance: Central bank communication about the expected future path of monetary policy.
Interest on reserve balances (IORB): Interest paid by the Fed on banks’ reserve balances held at Federal Reserve Banks. The primary monetary policy implementation tool.
Interest on reserve balances (IORB) rate: The administered interest rate paid on IORB, acting as a reservation rate for banks.
Liability: Money owed; debt.
Liquidity: The ease with which an asset can be converted to cash without significant loss of value.
Monetary policy: Actions taken by a central bank to achieve its goals, such as maximum employment and stable prices.
Monetary transmission: The process through which monetary policy changes impact economic variables.
Money multiplier: In a fractional-reserve system, the theoretical maximum amount of money created from each additional dollar of reserves.
Open market operations: The Fed’s buying and selling of government securities to influence reserves in the banking system.
Policy rate: The interest rate used by a central bank to communicate its monetary policy stance; in the U.S., the federal funds rate.
Reservation rate: The minimum acceptable rate of return for banks’ lending decisions.
Reserve balances: Banks’ deposits held at a Federal Reserve Bank.
Reserve requirement: The percentage of deposits banks are required to hold as reserves. Currently set to zero by the Federal Reserve.
U.S. Treasury securities: Debt instruments issued by the U.S. Treasury to finance government operations.
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